What Is Risk Management in Finance, and Why Is It Important?

What Is Financial Risk Management?

Financial risk management involves identifying the potential downsides in any investment decision and deciding whether to accept the risks or take measures to mitigate them. Financial risk management is a continuing process as risks can change over time.

There are risks in all investments. Successful financial risk management requires a balance between potential risks and potential rewards.

How Financial Risk Management Works

Risk is inseparable from return. Every investment involves some degree of risk. It is close to zero for U.S. Treasury bills but it can be very high for emerging-market stocks.

The problem is, a higher level of risk almost always means a higher potential return. The solution, from the investor’s point of view, is to diversify investment choices to mitigate overall risk.

Quantifying Risk

Risk can be quantified in both absolute and relative terms.

Risk management involves identifying and analyzing the sources of risk and making decisions about how to deal with it. It occurs everywhere in the realm of finance. For instance:

• An investor may choose virtually risk-free U.S. Treasury bonds over riskier lower-rated corporate bonds
• A fund manager who identifies currency price changes as a risk may hedge that risk with currency derivatives
• A bank checks the credit rating of applicants for personal lines of credit and grants or denies the applicant based on the results
• A stockbroker uses financial instruments like options and futures to offset potential losses in other investments
• A money manager uses strategies like portfolio diversification to mitigate the risk of losses in specific stocks.

Failures in Risk Management

Inadequate risk management can result in severe consequences for companies, individuals, and the overall economy.

The subprime mortgage meltdown that led to the Great Recession of 2007-2008 stemmed from a failure to manage risk. Banks and other lenders gave mortgages to people regardless of their credit ratings or income. The mortgages were then sold to investment firms, which packaged and resold them to investors as mortgage-backed securities (MBSs). This was profitable until rising mortgage default rates rendered the MBSs worthless.

Risk Management Techniques

The following are some of the most common risk management techniques.

• Avoidance: The most obvious way to manage risk is to avoid it. Some investors make their investment decisions by cutting out volatility and risk completely. This means choosing the safest assets with little to no risks.
• Retention: This strategy involves accepting any risks as the price to be paid for the chance of high returns.
• Sharing: Risk can be shared among two or more parties. For instance, insurance companies pay reinsurers to cover potential losses above specified levels.
• Transferring: Risks can be passed on from one party to another. Health insurance allows consumers to transfer the risk of expensive medical costs to an insurance company in return for payment of regular premiums.
• Loss prevention and reduction: Rather than eliminating risk, many investors mitigate it by balancing volatile investments, such as growth stocks, with more conservative choices.

Using Standard Deviation for Risk Management

Investment risk is measured by its deviation from an expected outcome. A result may differ from the expected outcome, for better or worse. This deviation is expressed in absolute terms or relative to something like a market benchmark.

To achieve higher returns, one expects to accept greater risk. It is also generally accepted that increased risk means increased volatility.

While investment professionals constantly seek to reduce volatility, and sometimes achieve it, there is no clear consensus on how to do it.

How much volatility an investor should accept depends entirely on their risk tolerance. This depends on the individual’s circumstances, income, long-term goals, and personality.

Measuring Volatility

One of the most commonly used absolute risk metrics is standard deviation, which is a statistical measure of dispersion around a central tendency.

To determine standard deviation, take the average return of an investment over a period of time and find its average standard deviation for the same period.

Normal distributions (the familiar bell-shaped curve) dictate that the expected return of the investment may be one standard deviation from the average 67% of the time and two standard deviations from the average deviation 95% of the time.

This provides a numeric risk evaluation. If the risk is tolerable (financially and emotionally), the investment gets the green light.

Types of Risk Management

Beta and Passive

One risk measurement calculates the drawdown, which is any period during which an investment’s return is negative relative to a previous high mark. A drawdown measurement addresses three factors:

• The magnitude of each negative period (how bad)
• The duration of each (how long)
• The frequency (how often)

For example, in addition to wanting to know whether a mutual fund beat the S&P 500, we also want to know its comparative risk. One measure for this is beta. Also called market risk, beta is based on the statistical property of covariance. A beta greater than 1 indicates more risk than the market, while a beta less than 1 indicates lower volatility.

Beta helps us to understand the concepts of passive and active risk. The graph below shows a time series of returns (each data point labeled “+”) for a particular portfolio R(p) vs. the market return R(m).

The returns are cash-adjusted, so the point at which the x and y axes intersect is the cash-equivalent return.

Drawing a line of best fit through the data points allows us to quantify the passive risk (beta) and the active risk (alpha).

The gradient of the line is its beta. So a gradient of 1 indicates that for every unit increase in market return, the portfolio return also increases by one unit.

A money manager employing a passive management strategy can attempt to increase the portfolio return by taking on more market risk (i.e., a beta greater than 1) or decrease portfolio risk (and return) by reducing the portfolio beta below one.

Alpha and Active

If market or systematic risk were the only influencing factor, then a portfolio’s return would always be equal to the beta-adjusted market return. But this isn’t the case.

Returns vary due to a number of factors unrelated to market risk. Investment managers who follow an active strategy take on other risks to achieve excess returns over the market’s performance, including:

• Tactics that leverage stock
• Sector or country selection
• Fundamental analysis
• Position sizing
• Technical analysis

Active managers hunt for an alpha, the measure of excess return.

In our diagram example above, alpha is the amount of portfolio return not explained by beta, which is represented as the distance between the intersection of the x and y axes and the y axis intercept. This can be positive or negative.

In their quest for excess returns, active managers expose investors to alpha risk, the risk that the result of their bets will prove negative rather than positive. For example, a fund manager may think that the energy sector will outperform the S&P 500 and increase a portfolio’s weighting in this sector. If unexpected economic developments cause energy stocks to sharply decline, the fund will underperform the benchmark.

The Cost of Risk

The more an active fund and its managers can generate alpha, the higher the fees they tend to charge.

For purely passive vehicles like index funds or exchange-traded funds (ETFs), you’re likely to pay one to 10 basis points (bps) in annual management fees. Investors may pay 200 bps in annual fees for a high-octane hedge fund with complex trading strategies, high capital commitments, and transaction costs. They may also have to give back 20% of the profits to the manager.

The pricing difference between passive (beta risk) and active strategies (alpha risk) encourages many investors to try and separate these risks, such as paying lower fees for the beta risk assumed and concentrating costly exposures to specifically defined alpha opportunities.

This is popularly known as portable alpha, the idea that the alpha component of a total return is separate from the beta component.

For instance, a fund manager may claim to have an active sector rotation strategy for beating the S&P 500 with a track record of beating the index by 1.5% on an average annualized basis. This excess return is the manager’s value (the alpha), and the investor is willing to pay higher fees to obtain it.

The rest of the total return (what the S&P 500 itself earned) arguably has nothing to do with the manager’s unique ability. Portable alpha strategies use derivatives and other tools to refine how they obtain and pay for the alpha and beta components of their exposure.

Example of Risk Management

From the introduction of the S&P 500 Index in 1957 and the end of 2023, the average annualized total return of the S&P 500 was about 10.26%. This number reveals what happened for the whole period, but does not say what happened along the way.

The average standard deviation of the S&P 500 over that time was about 15.28%. This is the difference between the average return and the real return at most given points throughout the history of the index.

When applying the bell curve model, any given outcome should fall within one standard deviation of the mean about 67% of the time and within two standard deviations about 95% of the time.

Thus, an S&P 500 investor could expect the return, at any given point during this period, to be 10.26% plus or minus the standard deviation of 15.28% about 67% of the time. They may also assume a 27% (two standard deviations) increase or decrease 95% of the time.

If they can afford to wait out those losses, then they invest.

The Bottom Line

Risk is an important part of the financial world. The word has negative connotations since there is the potential for financial loss.

But risk isn’t always bad because investments that have more risk tend to come with the biggest rewards. Knowing what the risks are, how to identify them, and employing suitable risk management techniques can help mitigate losses while you reap the rewards.